Can Natural Gas Prices Recover?

The energy source is down but not out. There are steps afoot that would boost demand.

BOSTON ( TheStreet) -- Natural gas prices, long thought to be correlated to oil, have diverged in recent years, fueled by lower production costs and new forecasts of greater-than-expected global shale reserves. As shown in the graph below (with futures prices displayed for 2012 dates), prices for both fuels were severely hurt by the Great Recession, yet crude oil prices have been on a steady ascent, while natural gas is stagnant.

One of the oft-quoted pieces relating to the relationship between the two fuels is a white-paper from 2007 put out by the Federal Reserve Bank of Dallas. The report, "What Drives Natural Gas Prices?", discusses various metrics used in the energy industry to relate the pricing between natural gas and oil. One metric, called the 10-to-1 rule, states that a barrel of oil should be worth 10 times that of natural gas.

With crude oil currently trading for around $101/barrel, this "rule" would indicate that natural gas should be trading for around $10. With natural gas trading for around $4.30, the metric is either completely inaccurate or natural gas is wildly undervalued. In the chart below, it's apparent that while the 10-to-1 rule was fairly consistent from 1992 through 2008, the recent 25-times ratio deems this rule invalid in today's environment.

Why has there been such a dichotomy between the pricing of the two fuels? For one, technological innovations stemming from horizontal drilling and hydraulic fracturing have made it possible to extract shale gas more economically. These lower costs of shale-gas production have led to increased supply (in the past decade, shale gas production has increased 10-fold), leading to the depressed pricing over the past several years. And according to a recent EIA report, global shale reserves are significantly higher than once thought.

Many energy companies that rushed into shale gas production are now using the same technology to extract oil. The latest Baker Hughes rig count, a popular gauge for the oil and gas industry, showed a 76% increase in active oil rigs over last year, while gas rigs have fallen 10%. With oil at $101/barrel, it's not shocking, given the profits that can be made in oil versus gas.